This Stock Was up 15% in One Day — and It’s Just Getting Started…

Business school professors often speak of the “efficient-market hypothesis,” which posits that stock prices reflect all available public information and therefore are never overvalued or undervalued; they’re, instead, are perfectly valued. These professors are wrong. In many instances, the market gets it wrong, and a stock can remain mispriced, even after an important piece of news is digested by buyers and sellers.

I was reminded of this after looking at the stock action of Assured Guaranty (NYSE: AGO) on Friday, April 15. The company’s stock rose 24% in just one day, but as you more deeply analyze the news that affected the stock, it’s easy to conclude that shares should have risen by a good deal more than that. The process may take several weeks or months, but when complete, this $17 stock could shoot up into the low to mid-$20s.

Bank of America’s mea culpa
Assured Guaranty provides insurance to bond buyers. If those bonds default, then the buyers can make a claim. It’s been a very lucrative business for many years, controlled by Assured Guaranty, MBIA (NYSE: MBI) and Ambac Financial (Nasdaq: ABFXQ). Yet the mortgage crisis hit the industry like a storm, and MBIA and Ambac are now so weakened that they’re no longer in a position to underwrite any new insurance. Assured Guaranty now has the business all to itself.

Assured has felt the effects of the mortgage crisis itself, although in a more moderate form. Shares took a severe hit when the economy slumped and have clawed back only part of the way. Blame it on Bank of America (NYSE: BAC). Assured Guaranty has long contended that it was deceived and given improper information about the actual financial health of the bonds that BofA was issuing and Assured Guaranty was insuring. On Friday, BofA finally acknowledged its misdeeds, agreeing to pay Assured Guaranty more than $1 billion and to cover 80% of all future losses on any BofA-issued bonds that go into default (with a ceiling of $6.6 billion in liabilities). In one fell swoop, Assured Guaranty now has more cash and fewer liabilities. The timig could not be better. Assured Guaranty was frozen in its tracks while rating agency Standard & Poor’s is reviewing the company’s financial health to see if the insurer is strong enough to withstand future potential claims. Assured Guaranty has not been able to book new business while that investigation is underway.

With that overhang, investors had been steering clear. Although Assured Guaranty had promised to strengthen its balance sheet without hurting its stock, investors fretted that efforts to meet S&P’s tougher standard would mean tens of millions of new shares would need to be issued. That’s no longer the case. In all likelihood, the BofA settlement means Assured now has the capital in place to please the bond agency firms.

Egan-Jones, a ratings agency rival to S&P, told clients that the BofA deal “goes a long way in enhancing credit quality,” adding that “Assured has weathered the worst of the credit crisis and is now benefitting from the improving conditions.” The ratings firm boosted Assured Guaranty’s credit rating from “BBB” to “A-” as a result. Might S&P take a similar improved view when its review is completed later this quarter?

A compelling value

Investors might assume that shares of Assured Guaranty are quite cheap, trading at about five times this year’s earnings estimates. Yet that’s not how most investors assess the stock. Instead, it is viewed in the context of book value (assets minus liabilities). The insurer’s book value steadily rose throughout the past decade into the mid $20s, which is right where shares traded from 2006 to 2008. Now, book value exceeds $25 and analysts at UBS think it will approach $30 by the end of this year. (Notably, that forecast was developed prior to the BofA settlement and, when Assured updates its balance sheet, that figure is likely to move into the low $30s.)

Meanwhile, shares trade for just $17.50, despite Friday’s impressive spike. The ongoing problems concerning budgets at the state and city level mean that shares will not move all the way up to book value just yet. Instead, I look for that gap to slowly narrow, thanks to three catalysts:

  1. Management will provide a lengthy update when first quarter results are released. That should help move the share price up somewhat
  2. Then, S&P will weigh-in later in the quarter, and the odds have increased that it will not force Assured Guaranty to raise further capital.
  3. As the summer progresses, investors are likely to see that state and local finances are not spiraling down yet further and the likelihood of a major default becomes even more remote.

Action to Take –> These three factors may push shares a lot closer to book value — some 50% above current levels.

The real charm of this business model lies in the fact that the company has seen its rival buckle under the weight of the mortgage crisis, leaving Assured Guaranty as the sole municipal bond insurer. This is enabling the company to price aggressively to capture even greater profit spreads when policies are written. That is likely to be in evidence again later this summer as the S&P-induced moratorium is lifted.